Thursday, February 26, 2009

Finance is pro-cyclical

Megan talks about why it would be terrible for banks to recapitalize the traditional way -- wipe out equity holders (who are now 100% moral hazard players) and convert debt holders to equity:

It's easy to blithely say "Why don't they just make the bondholders take a haircut?" Harder when you think about who those bondholders are: insurers. pension funds. the bond component of your 401(k). Financial debt makes up something like a third of the bond market, and the largest holders are pensions and insurers.

The insurers are the biggest problem, because they're just so heavily regulated. They're not allowed to hold risky assets. Convert their bonds to equity and they will be forced to dump that equity at prices that will trend towards zero. Many insurers will see their capital impaired below the regulatory limits, requiring a government bailout.

Pension funds are the next biggest problem. They're already in big trouble because of stock market declines. The bonds are the "safe" portion of their portfolio, the stuff that's supposed ot be akin to ready cash. Convert their bonds to equity--or worse, default--and suddenly they're illiquid and even further underwater.

Nor is the 401(k) problem small. Bond funds are typically held most heavily by the people closest to retirement; they're for income, not capital gains. What is your mother going to do when a third of her mutual fund income gets converted to equity that produces no cash and can't be sold because the insurers have all had to dump their shares on the market at once? Or simply disappears into the land of bankruptcy lawsuits?

We are back to deciding where the losses, that have been realized in the market, will be borne, as the Fed and the Treasury have decided that those who enjoyed the gains cannot possibly bear the losses. The thing is that the losses are already there, we're just talking about whether or not to recognize them, and if they are recognized, shift them around.

Banks are naturally leveraged institutions, and are therefore extremely pro-cyclical. If they found that their loans are suddenly being repaid, or that there are more good credit risks out there than before, they would begin functioning normally again. But the Obama administration has transferred money to banks which keeps them from going under, but does nothing for the quality of those they have made loans to or those they might make loans to -- US households. This saves bank investors, and bank employees, but does nothing for the economy. Instead, Obama is ushering in double digit unemployment as he adds to fiscal drag through higher taxes.

People talk about Japan's "lost decade", and sometimes "second lost decade", but in fact it is 25 years into stagnation with no end in sight. Japan reached this situation by propping up zombie banks, believing that poorly conceived "infrastructure" projects were "stimulative", and raising taxes. As of this week, Obama has hit the trifecta. Geither makes Paulson look good. Is it conceivable that, four years from now, Obama will make Bush look good? The mind boggles.